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Subprime Mortgage Crisis

To understand the nature of the subprime mortgage crisis and how we got ourselves into such an incredible mess (as well as what that mess really is), we need to go back several decades and examine how the financial markets have evolved during that period of time.

We’ll start with a mathematician by the name of John Forbes Nash. If that name sounds vaguely familiar, it’s probably because his life was portrayed in the movie “A Beautiful Mind” starring Russell Crowe.

While the film did a great job of highlighting Mr. Nash’s mental illness, it did a poor job of informing the audience of the important role his game-theory mathematical equations were to modern day finance.

The secondary mortgage market would not have been possible without the mathematical equations that he developed.

Before the introduction and development of the secondary mortgage market, borrowing money to buy a home was rather simple. You applied for a mortgage loan at your bank, and if your banker determined that you were likely to be able and willing to repay the loan, he would loan some of the bank’s deposits to you for the purchase of the house.

The bank needed the deposits in order to make the loan. And if the bank didn’t have enough money in its deposits, it didn’t make the loan.

Rather than come right out and announce that they didn’t have enough deposits available to make any more home loans, banks would increase the interest rate charged and borrowers would choose to apply at a different bank that offered lower rates.

It was a simple illustration of supply and demand working properly in the free market. If there weren’t enough deposits at the banks, interest rates would rise and borrowing would slow.

If the banks were flush with deposits, interest rates would come down as the banks competed with each other for additional business.

The free market would find the perfect equilibrium between the borrowers and the banks through the constant adjustment of interest rates.

The mathematical equations of John Nash made it possible for investment banks to combine those loans into packages and sell those packages to investors.

By being able to tap into larger pools of money besides just deposits at banks, borrowers seeking a home mortgage loan were able to obtain lower rates on their mortgages.

Nash’s equations simply made for more efficient means for borrowers to tap into large pools of money that were available.

The loans were still being made one at a time. But the banks, with the help of Wall Street (which received a commission for facilitating the transaction), could combine hundreds of loans and sell the package to very large investors, such as insurance companies, mutual funds, foreign companies, and even foreign governments.

At that point in time, there still wasn’t a problem. That was how the secondary mortgage market formed and operated in the 1980’s.

Wall Street Firms Got Greedy

Wall Street Corrupts the process

But things begin to change in the 1990’s. Wall Street wasn’t satisfied with just getting a commission. As usual, Wall Street wanted more: more money, a bigger piece of the pie, and more profits. How else could all those Wall Street people afford to buy multi-million dollar homes in the Hamptons?

And this is where the problem begins.

Wall Street made some changes to what was up to that point a very straightforward process. Wall Street added derivatives to the mix.

Instead of just packaging a group of say, 1,000 mortgages together and selling them for the interest that they paid, Wall Street included complicated, opaque derivatives in the package.

The first instance of credit derivatives being used on Wall Street was 1981 when Salomon Brothers arranged for IBM and the World Bank to swap debt payments in Swiss Francs and German Marks for dollar obligations.

The practice spread like wildfire on a dry tundra during the 1990’s.

Wall Street firms deliberately structured these packages to be opaque and confusing. That way, the investors weren’t really sure what they were getting.

Let’s take a look at a simple example to expose the truth. Suppose 500 people each owe me $10.00. That is $5,000 in total owed to me. These people are paying me seventy cents per year in interest (7%).

Suppose that I package the 500 loans together and sell them to you. You would then be able to collect the interest as well as the principal when it is paid back. We will call this a five thousand dollar package.

I might sell this package of loans to you for $4,925 to allow for approximately 1.5% of the loans not getting repaid.

Now, what if that five thousand dollar package didn’t contain 500 loans of ten dollars each? What if it only contained something like 200 or 300 loans for ten dollars each, and of those, more than half were subprime and of questionable ability to repay, and the remainder of the “five thousand dollar package” was used lottery tickets?

Would you still want to pay $4,925 for a package of those loans? Of course not! You would only be owed about half of what you paid, and you probably will not receive even half, because so much is owed by borrowers with poor credit ratings who have difficulty making payments on time. There is no way that “package” would be worth $5,000.

Yet Wall Street put packages like that together. Where was the value for the other half of the package?

From derivatives.

Derivatives are nothing more than speculative bets, thus the example of used lottery tickets.

CDO’s (collateralized debt obligations) are comprised of a combination of mortgages and derivatives very similar to the above illustration.

And therein lies the problem. The value of TRILLIONS of dollars of CDOs is based upon complex, opaque derivatives of very little if any tangible value. The latest figures that the amount of derivatives currently outstanding worldwide exceeds $540 TRILLION.

So here we are in 2008 and these mortgage-backed “securities” have been created by Wall Street by the trillions upon trillions of dollars in the last 20 years.

The housing market is going one way: backwards.

And everything worked fine, until the housing market turned down and just a few too many subprime borrowers begin to default on their loans.

And when those borrowers stopped making their payments, some holders of the mortgage back securities wanted to cut their losses and sell.

And then comes the 500 trillion dollar question: sell to whom?

You see, every other holder of mortgage-backed securities was experiencing the same thing: an increased number of defaults.

These packaged mortgage securities are not traded on an exchange like stocks. They are unregulated by the government. The buying and selling of them is done privately.

The problem is that the largest portion of value in these various mortgage-backed securities is based upon derivatives that are of “questionable” value at best. When a hedge fund, bank, or insurance company decided to sell their “investments” in CDO’s in the later summer of 2007, there simply were no buyers.

The genie was let out of the bottle, and now there is no way the genie can be put back into the bottle again. Specifically, the genie is the fact that the CDO’s, MBS’s, and most “structured finance” products are not worth anywhere near what they are supposed to be worth, or what Wall Street firms claimed that they were worth.

The buyers of these financial products have now realized en masse that they have been sold a package that isn’t worth anything near what they paid.

Needless to say, investment buyers around the world have stopped purchasing mortgage-backed securities, resulting in the funding for mortgages drying up. Everything from First time home buyer loans to jumbo mortgages are now much more difficult to obtain.

And this will cause massive changes to the economy through a domino-type effect. The first area to be effected has been real estate. It has already started, but what you are seeing is just the beginning of the first inning, we’ve still got 8 and one-half innings to go.

Basically, the secondary mortgage market is barely functioning, if at all. Banks now have to lend from their own deposits. Needless to say, last year, when banks and mortgage companies could sell the loan as part of a package, they were not nearly as concerned with the borrower being able to pay back the loan. That would become somebody else’s problem.

Now that banks have to loan from their own funds, they have become very, very concerned about the borrower’s ability to repay. Banks don’t want to take losses. They want profits. And they are not going to loan to questionable borrowers.

That mean that millions of people who previously qualified for mortgage loans under the old rules no longer qualify. Thankfully, many states still provide first time home buyer grants to help 1st time buyers qualify for their first mortgage.

The days of the “no-doc” loan are gone. The days of the real estate boom are gone. We are now headed rapidly in the other direction: real estate bust.

In the coming months, billions upon billions worth of mortgages that had low initial “teaser” rates will be resetting higher. Much higher. Many of these people will not be able to afford to keep their home.

Foreclosures are already increasing rapidly. Expect this trend to continue for at least the next 2 years. It may take 3 to 4 years for the glut of foreclosures and extra inventory to be worked out of the system.

Because of this, look for real estate prices to continue to fall. Again, expect this trend to also continue for the next 2 to 4 years. But even when it does come back, without a prosperous secondary mortgage market, real estate will never be like it was in the late 1990’s and early 2000’s.

When you consider that construction and real estate accounts for 20% of the US economy, expect real estate to drag down the rest of the economy. Millions of construction workers, real estate brokers, mortgage loan officers, as well as workers in related industries such as appliance manufacturers, carpet manufacturers, window companies, etc, will all be searching for other lines of work.

The level of business in real estate and construction will not support the amount of labor and careers that it did 2 years ago. It may not even support half of it.

Warning: The Television Talking Heads Will Announce Over and Over that the “Worst is Behind Us”

What else can they do? Do you think they can tell the truth and announce that it is going to get worse? That would cause consumers to prepare for the coming hard times by reducing their spending and hoarding cash. The very action of consumers reducing spending would hurt an already critically-ill economy even more.

Forget it. You will not be told the truth by the mass media.

The worst will not be behind us until the mess has been cleaned out of the system, and that is going to take, at a very minimum, 2 to 3 more years. That’s a minimum. It could be much longer, depending upon how the government handles the mess.

Governments usually don’t do what’s best for the population as a whole. Governments typically do what’s best for the few well-connected. Expect big, fat-cat bankers and Wall Street Firms to be bailed out, but very little in the way of real help for the common man.

Unfortunately, the common man will suffer the most.

Despite “official” government statistics that proclaim the economy isn’t that bad off, the truth will be the exact opposite. The economy is in a downward spiral that will not be stopped.

The only way to stop it would be for banks to go back to their loose lending standards and for the secondary mortgage market to go back to doing billions upon billions of dollars per week in CDO’s and MBS’s (collateralized debt obligations and mortgage-backed securities).

But investors no longer want to purchase CDO’s and MBS’s that are full of toxic derivatives, now that the secret about the true value of those derivatives is out in the open. And no bank wants to make reckless loans with their own capital at risk. That only leaves us on the path we are on: a cleaning out of the real estate mess.

Lower interest rates will not help. The interest rates on home mortgages could go to zero. But what good would that do if the banks will not grant you a loan? It doesn’t matter what the published interest rate is. If the bank won’t give you a loan, the interest rate is merely for show.

Why is the US Economy Facing A Recession?

Readers Question: Why is the US economy facing an economic meltdown?

The US economy faces many severe problems, a falling stock market, record levels of public debt, banks on the verge of bankruptcy, frozen money markets, a plummeting dollar and the imminent threat of a recession. How did the US economy get into such a desperate situation?

The Housing market

The housing market plays a crucial role in determining consumer spending and therefore the rate of economic growth. When house prices are rising, consumers experience an increase in wealth; this boosts their confidence and enables them to remortgage and gain equity withdrawal to spend. When house prices fall, the opposite happens.

The Housing Bubble.

Up until 2006, US house prices rose rapidly; against a backdrop of rising house prices many analysts felt that even risky mortgage loans were safe and this encouraged even more unsuitable mortgages. For example, it was hoped 100% mortgages would be easier to pay back because rising prices would give homeowners an effective deposit.

The combination of low interest rates, aggressive marketing of mortgages and overly optimistic predictions for the housing market caused house prices to rise. However, the ratio of house prices to income went far above the long run trend rate; making mortgages increasingly unaffordable for first time buyers. Then in 2006 the Fed were forced to raise interest rates to over 4% because of inflationary pressure in the economy. This increase in interest rates caused many mortgage owners to struggle with their repayments. Also, there was another problem – many new mortgages were ‘balloon mortgages’ this means that for the first two years homeowners had a specially low introductory rate. However, after two years, the mortgage rate suddenly shot up increasing monthly payments very significantly. Therefore, first time buyers who had stretched themselves to get a mortgage suddenly found themselves with a large increase in monthly payments. There are several examples of homeowners with mortgage payments greater than their total income. These mortgages should never have been sold, but, in the housing boom there was a lack of self regulation. The needs of the consumers were ignored in the pursuit for selling ‘profitable mortgages’

The Housing Bubble Bursts

Therefore, with a rise in defaults and fall in affordability, the US housing market turned. Suddenly after years of growth, the ‘unthinkable’ happened and house prices started to fall. This came as a shock to many who assumed house prices could only rise. Therefore, people who had been speculating in the housing market felt this was the time to get out and sell. Therefore, prices fell even more. Since their peak in 2006, house prices have fallen by 10% (in some areas it is much higher, the housing market is very localised). Furthermore, there is still the prospect of even more falls in house prices. As house prices fall consumers have less confidence to spend. There has also been a worrying increase in unemployment in real estate related jobs, such as construction.

The Credit Crunch

The problems in the US housing market and in particular the subprime mortgage sector soon spread to the rest of the finance system. Many big investment banks and commercial banks had been enthusiastic purchases of these CDOs. Basically, big banks had been refinancing these risky mortgage loans. When mortgage defaults started to occur, the commercial banks realised they were facing huge losses. Their losses were exaggerated by the risky nature of the loans. Some hedge funds collapsed completely. Despite the magnitude of the defaults, many of the big banks could afford to write off billions of pounds and still remain solvent.

However, the experience left Wall Street and the global finance system realising the dangers of risky lending. Therefore, the market sentiment changed to one of great conservatism. Banks were reluctant to lend to anyone, even each other and usually secure lending. This led to a shortage of funds in the money markets (such as interbank lending). This credit crunch is basically about a shortage of liquidity in the finance sector. The effects are that ordinary borrowing becomes more expensive and more difficult. Both the UK and US have seen most ‘subprime’ lending products withdrawn.

The credit crunch has also caused great difficulties for banks such as Northern Rock in UK and Bear Sterns in the US. Basically the banks couldn’t raise enough money on the money markets so had to resort to some kind of rescue package. The concern is that more banks could suffer a similar fate and future bank rescues will be more difficult.

Because of the credit crunch, since July, the monetary authorities have been forced to inject liquidity into the money markets three times to avoid a complete shortage of funds. However, there is no guarantee that the markets won’t keep freezing again.

Effect on Consumers and Economic Growth

Falling house prices, falling confidence, higher costs of borrowing have all contributed to a fall in consumer spending and it is this which is the main factor causing a downturn and likely recession. Furthermore, the credit crunch has caused difficulties for many borrowers, who now struggle to borrow at affordable rates. The US also has very high levels of consumer borrowing, therefore, increased cost of borrowing has caused widespread problems. – although the rate cuts by the Fed have made it less painful, it may still not be enough.

It Gets Worse

On its own the Housing crash and credit crunch would cause serious problems. However, the US economy has other underlying problems which makes it more difficult to deal with the problem.

Devaluing Dollar. In one sense the depreciating dollar is helping to increase exports and maintain growth in the export sector; to some extent this may counter the fall in consumer spending. However, the depreciating dollar is contributing to both cost push inflation and declining living standards. This means the US could face the unpleasant occurrence of both inflation and lower growth. It makes the job of the Fed more difficult; in particular rate cuts further weaken the dollar and increase inflation. At the moment, the Fed have decided the recession is more serious than inflation, and rates have been cut.

Current account deficit. The current account deficit is an indication of an unbalanced economy – too much spending, low savings ratio. A downturn in the economy and depreciation in dollar are necessary to deal with this.

National Debt. The US national debt stands at 65% of GDP, (even more if you include future pension liabilities). This gives the economy little room for expansionary fiscal policy. It means the US pays a lot in debt interest payments and the forthcoming recession will only aggravate the debt situation.